TD Bank: Dumping Schwab Shares Is A Good Thing (NYSE:TD)

Note: All amounts are in Canadian Dollars unless specified otherwise.

In our last coverage of The Toronto-Dominion Bank (NYSE:TD, TSX:TD:CA), aka TD Bank, we gave the financial behemoth one thumb up. The valuation was compelling and the risks felt fully discounted.

Based on that chart and the sentiment, it just feels that it is not a bad time to at least get some exposure here, and TD offers a good start point. We are moving this to a “Buy” and think the Green Machine offers a relatively attractive point for those who have low to none exposure to the Canadian financial sector.

Source: Valuation Gets More Interesting.

That worked right until the results, as TD (price below in USD) kept up with the broader indices.

We break down the hits and the misses and tell you why we are moving back to the sidelines.

Q2-2024

TD missed estimates by about 2% as consensus was at $2.09 for the adjusted EPS number. The headline number came in a lot lower as there was a considerable additional provision for the Anti-Money Laundering, i.e., AML, fine.

There were many moving parts to the miss on the adjusted EPS. Notable items included very low insurance income and much higher expense ratios. Non-interest expenses were 7% higher year over year. These would have created a far bigger miss if not for stronger net interest income and lower credit losses. While the provision for credit losses was higher significantly year over year, it was still lower relative to where everyone expected this to go.

Our take here is that this is a late cycle in the economy and at the tail end of a big hiking cycle. We expect that this will be noisy, but the worst is ahead, not behind. The bank’s capital ratios were lower as the earnings were more than offset by dividends buybacks and charges.

The bank’s restructuring program looks almost finished, and it has delivered the big savings already. We think the expense rise will unfortunately offset this as the bank tries to plug holes in its AML defenses.

Verdict

The big provision is even larger than what we anticipated. We had previously opined that a $2 billion fine would not faze us. We are now looking at $3.0 billion USD, which is circa $4.0 billion in Loonie bucks. This is also higher than what anyone else was thinking. TD added The Charles Schwab Corporation (SCHW) to immediately shore up the capital ratios by about 50 basis points. The sale will include 40.5 million shares and take down holdings from 12.3% to 10%.

Ideally, we would have considered selling the entire stake, but we are unsure if they would be able to do it today. SCHW trades at a 21X multiple of expected 2024 earnings, compared to TD at less than 10X. We also have zero faith in those 2025 estimates for SCHW and think the longer-term outlook is very poor.

So on a relative basis, having the capital for its banking is a better deal here for TD.

In the medium term, TD faces substantial headwinds from the Canadian housing bubble deflation. We have no prior model for how this plays out, as we have never delivered such a rapid hike cycle on such an overvalued market. There is also the fact that Canada is primarily riding the 5 year resetting mortgages. Even 4 rate cuts won’t change the fact that most people will have their mortgages adjusted higher in the months ahead. The price adjustment for homes themselves has been delayed by the worst immigration policy that we have ever seen. That fact (not opinion) can be seen in the chart below.

But the drop in housing starts will definitely impact the economy and construction jobs. In our defense, we are only the second worst in this category.

So things will likely get rough ahead, but the critical question here is “is it priced in?” Certainly, if you look at Royal Bank of Canada (RY:CA) trading at 2.6X tangible book, you have to answer that in the negative. TD, on the other hand, looks well priced for its franchise. The bank has historically held a premium to the group, and you can see the spread between RY and TD as a potential upside indicator.

On the downside, you can look at whether the AML fines essentially damage the TD reputation in the US. We actually think that is certainly probable over the medium term. So your downside risk is a valuation contraction down to the pariah of the group, Bank of Nova Scotia (BNS:CA), which trades 0.3X multiples lower.

We think The Toronto-Dominion Bank stock is a great play for those looking for value in the financial space, but one we believe will still be a tough slog over the next 12 months. Last time around, we thought there was an adequate buffer in the price. The far larger than expected fine, the price gain in the stock and the worsening outlook for the economy, have tempered our view. We are hence moving back to a neutral/hold rating here.

The Toronto-Dominion Bank PFD SER 9 3.7% (TSX:TD.PF.E:CA)

We have previously shared ideas for covered calls on this stock, and those remain viable ways to generate better risk-adjusted returns. But today, we will focus on another avenue here for those expecting firmer longer-term bond yields. TD.PF.E has a remarkably low yield at present, of just 3.41% at the price shown below.

This resetting preferred share is due to reset at the end of October 2025. The reset is based on the 5-year Government of Canada (GOC-5) bond yield plus 2.87%. There are 3 other preferred issues coming up for reset ahead of this one, and all 3 have lower spreads.

1. The Toronto-Dominion Bank 5 YR RST PFD 1 (TD.PF.A:CA), GOC-5 plus 2.24%, on October 31, 2024.
2. The Toronto-Dominion Bank PFD SER 5 (TD.PF.C:CA), GOC-5 plus 2.25% on January 31, 2025.
3. The Toronto-Dominion Bank PFD-7 (TD.PF.D:CA), GOC-5 plus 2.79%, on July 31, 2025.

So if TD has to call only one of these, the odds are high that it is TD.PF.E. Of course, the exact interest rates at the time of the reset, as in the GOC-5 yields, play a role as well. While we expect more rate cuts from the Bank of Canada, we think the GOC-5 has discounted all those and more. As such, we see room for GOC-5 to move higher from here. TD.PF.E is very likely to be called and offers yield to call of about 8%. If it is not called, based on the present GOC-5 rates, you are looking at about a 5.87% yield on par and a 6.17% yield at the current price. For TD, that is not a bad deal. But your mileage will vary depending on your outlook for interest rates.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult a professional who knows their objectives and constraints.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.